1st Quarter 2013
he first quarter of 2013 was unusual for fixed income markets. The two primary components, corporate and government debt, went in opposite directions. US government debt declined while US corporate debt rallied. The dollar rose slightly, but largely as a result of a large decline against the euro. Relative to emerging market currencies, the dollar lost ground. Newgate’s Total Return Income Portfolio gained 5.1%, vs. a decline of 0.13% for the Barclay’s Aggregate Bond Index. Although the fall in the Index was modest, it was the first quarterly decline since Q1 2006.
The dollar’s strength can largely be attributed to a stronger than anticipated US economy and renewed economic weakness in Europe. Though very different, the recession in Europe and the crisis in Cyprus are connected because the common currency (euro) is not only their cause but also prevents their solution. One problem is debt, primarily impacting Greece, Portugal and Spain. If these countries had their own currency, they could devalue, pay off their debts and increase their global competitiveness. Another issue is excess capital entering a country’s banking system, as in Ireland and Cyprus. Floating currencies would rise and prevent excessive inflows. Regardless of the reasons, the inability of the European system to effectively cope with the crises keeps the US dollar firmly entrenched as the world’s reserve currency.
Discounts on closed-end funds remain consistent with historical averages. However, discounts have widened in areas such as senior loans funds. The best performing sector in the market last quarter was equity option funds. The funds employ covered call strategies, effectively modifying the return pattern of a stock into something that looks more like a bond. Writing calls on a stock limits the upside, but replaces it with the premium received from the option. This gives a yield consistent with, and usually greater than, the income received from a bond on the same company. In theory, this may reduce the interest rate exposure of the portfolio, though the correlation to equities increases. Our analysis of the Portfolio shows that its correlation to equities has not increased. Effectively, the option overlay funds act as a substitute for high yield funds.
The impact of allocating between these sectors can be seen in two funds currently in the Portfolio. The Global High Income Fund (GHI) is a leveraged fund with a 7.4% yield, trading at a 4% discount to net asset value. The Blackrock Global Opportunities Equity Trust (BOE) is unleveraged with a 9% yield and an 11% discount. The two funds are not interchangeable, but this example illustrates how value can be found by looking beyond traditional fixed income sources of income.
Historically in the fixed income markets, the greatest source of safety has been in US Treasuries. Given the Fed’s intervention and artificially low interest rates, we believe that is no longer the case. We have increased cash in the Portfolio while reducing allocations to equity oriented funds. Even with this cash, the Portfolio’s 5.8% yield remains attractive relative to traditionally structured fixed income portfolios. There is value in funds across many sectors, but we remain mindful that we are still in a very uncertain macroeconomic environment.